We expect a more micro market in 2010, after two years where macro themes drove emerging equity markets. Economies and earnings are recovering and it is likely too soon in the cycle for a major peak in EM equities. However, we do face the headwinds of monetary policy tightening (first in Asia and then the US) and a higher oil price. Our scenario-weighted year-end 2010 price target for MSCI EM is 1200, representing 28% upside from current levels.

The big one-way bet on cyclical over non-cyclicals is almost over, in our view.  We expect the return spread between cyclical and non-cyclical stocks to contract - similar to 1H04 - over next 3-4 quarters. Performance will be increasingly driven by stock- and sector-specific growth and earnings characteristics, and less by the macro recovery story. Cyclicals are already trading at premium valuations and will face a meaningful headwind if long rates rise and/or the curve steepens.   

Our view on China equities in 2010 is bullish. Accelerated growth, early-stage inflation and late policy exit could together create a temporary ‘Goldilocks' backdrop in China, which is bullish for equities. We would overweight mainstream and downstream recovery sectors, such as Consumer, Insurance, Internet & Media, Telecom and Energy - and underweight the "policy exit" areas, such as Banks, Properties and Materials. 

Regarding Japan, we may be closing in on a turning point. It's now all about monetary policy. We hold a generally constructive view of Japan's mid- to long-term prospects. Our argument is that a changed world - one without an apparent export escape route - will demand a structural loosening in Japan's monetary and fiscal settings. This loosening will eventually allow Japan to exit deflation and allow stocks to perform, but nothing good has come of this view this year.

A different view on inflation risk. With the flood of central-bank liquidity flowing through the system, Investors are concerned about inflation risk. But our analysis shows that inflation, after a cyclical bounce in the next few months, will likely remain low - potentially troublingly so - in 2010. In fact, we see uncomfortably low inflation as a much bigger risk to global equity markets in 2010 than either "traditional" inflationary pressures or the ballyhooed double-dip earnings scenario. 

*Mr. McVey is Head of Global Macro and Asset Allocation for Morgan Stanley Investment Management and is not a member of Morgan Stanley's Research Department.  His views are his own and may differ from the views of the Morgan Stanley Research Department and from the views of others within Morgan Stanley.

Behavior of the volatility index tends to reflect near-term investor fears and hedging activity in the market. We currently think the risk/return of owning short-dated options far outweighs the benefits of selling them, given the potential end of central bank easing, possible slower 4Q growth, macro headwinds, year-end hedging flows, and any bolt from the blue. We prefer selling longer-dated volatility, selling longer-dated correlation, and owning forward dividends.

Exploring M&A on the rebound. In the absence of any directional conviction, credit investors have been warily watching the budding M&A activity as the new-issue calendar stirs from its earnings-season slumber. The historical record suggests that the initial turn in M&A activity is far from a death knell for credit markets, as early-cycle activity is typically less aggressive, fosters much-needed asset sales, and could be seen to drive compression further across the quality curve.

Policy response to the Great Recession created a Great Swap. Assets, risk, borrowing and debt were swapped from the private sector to the public. The tail risk a year ago was a private balance sheet meltdown; looking ahead the tail risk is the public sector equivalent: serious sovereign stress. Even worse, the current crisis has come at a demographically inopportune time for many Western economies, just as public finances are set to be strained by baby-boomers' retirement.

Another stronger-than-expected jobs report hints that Australian growth is accelerating. This is not what I expect. Having avoided the worst of the global slump, I expected Australia's recovery would be relatively muted. If firms keep hiring as they have in the past two months, I would be wrong to be cautious. For now, I still expect that RBA tightening will quickly mute consumer spending. We expect the RBA to skip the December meeting before tightening again in February. 

Deterioration on the fiscal front. Credit markets may be excited at the prospect of Argentina regaining market access, but we suspect the bigger issue that may drive the outlook for Argentine asset markets will be the dramatic deterioration in Argentina's macro fundamentals, especially on the fiscal front. Indeed, after six years of consecutive fiscal surpluses Argentina may be faced with a federal deficit of 2.9% of GDP and a consolidated deficit of 4.7% of GDP in 2010.

Investors are starting to think about India's additional steps toward the 'exit' after the central bank's first steps in the October monetary policy review. The next step in reversal of easy monetary policy may be in January 2010 with a 25 bp rate hike, and potentially 125 bp more to come over the rest of calendar 2010. The first step in reversal of expansionary fiscal policy may come in February 2010 with a cut in expenditure to GDP and an increase in production tax rates. 

The current renminbi exchange-rate arrangement will remain at least through mid-2010, we continue to believe. While an exit from the current regime of a de facto peg against the USD may occur in 2H10, in our view, any subsequent renminbi appreciation against the USD is likely to be modest and gradual. We have highlighted the pros and cons of a renminbi de-peg and appreciation in the format of a hypothetical debate between a policy advisor and a fund manager.

Anticipating an even trickier exit. The start of the ECB's coming tightening campaign could be even trickier than the one in 2005 because a range of unconventional measures also need to be unwound. The ECB could already announce some of these steps as early as its 3 December meeting. In terms of the timeline, we would expect the active management of money-market rates back towards the refi rate to start in the spring, in time for a first rate hike around midyear.   

We still believe the Great Labor market recession will soon be over. The rise in the unemployment rate to 10.2% in October and steady declines in payrolls cast doubt on the sustainability of the new recovery. But that employment-economy disconnect can't continue indefinitely. We still see the recovery as sustainable, if moderate; indeed, stronger incoming data prompted us to raise our overall 4Q growth estimate from 2% annualized last month to 3% currently. 

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